How To Play Libya

The U.S. Oil Fund may be a great idea for a short-term trade, but for a long-term investment? Not so much.

The tense situation in the Middle East -- particularly, in Libya -- is driving a sharp rally in crude-oil futures and related ETFs. The $2.0 billion U.S. Oil Fund ( USO), which invests in front-month WTI crude oil futures contracts, opened up more than 7% this morning.

Investors looking to play this turmoil in the ETF space face an interesting choice: Use USO or turn to one of its competitors, such as the U.S. 12-Month Oil ETF ( USL) or the PowerShares DB Oil Fund ( DBO). USL and DBO differ from USO in that they do not track the front-month oil contract. Instead, they move out on the oil futures curve. USL, for example, invests an equal amount in the next 12 months' worth of oil futures contracts.

I'm asked very often which of these funds offers the best way to "invest" in crude oil. Fortunately, that's an easy question: With oil trading in contango, "investors" are better off using either USL or DBO than they are using USO. That's because contango is currently concentrated in the front month's futures contract, while out-month contracts are trading more or less flat.

For example, the March 2011 oil futures contract is trading around $91.29, while the April contract is trading around $94.72, a difference of 3.76%. Assuming that the spot price of oil stays flat, investors who buy the April contract and hold it for a month would lose 3.76%. (Note: That statement is loaded with assumptions and qualifications, but it is directionally correct.)

By contrast, the difference between the October 2011 and November 2011 oil contract is just $0.31, or 0.31% on a $99.20 contract. By positioning yourself further out the futures curve, you insulate yourself in part from the vicious contango that currently exists in the front-month contract.

This has paid off over the long haul. Over the past year, USL has traded up nearly 13%, while USO is up just 4%. Again, the choice for investors is simple.

For traders looking to make a short-term play on the current situation in the Middle East, however, the choice is not so easy. Just look at what happened today: USO opened up more than 7%, while USL opened up just 4%. The reason, again, is simple: Investors expect the turmoil in the Middle East to be short-lived and any supply disruptions to spike demand now. However, they believe this situation will have worked itself out by November.

People love to suggest that funds like USO are "bad" funds. They're not: They're simply designed for a single purpose, which is to provide exposure to the front-month WTI oil futures contract. If you're making a short-term trade, that may be a great idea. For a long-term investment, not so much.

At the time of publication, Hougan had no positions in the stocks mentioned.

Matt Hougan is president of ETF Analytics and global head of editorial for IndexUniverse. In this role, he serves as editor-in-chief of IndexUniverse.com and the Exchange-Traded Funds Report (ETFR), and senior editor of Journal of Indexes.

Under Hougan's leadership, the Exchange-Traded Funds Report is a repeat winner of the "Best ETF-Focused Publication" award at the Capital Link Closed-End Fund and Global ETF Conference. He was recently named to the ETFdb "ETF Hall of Fame."